The Quest for Aid Effectiveness

Has foreign aid been helpful for development? What helps and hinders it? What does the evidence say?

The key challenge facing foreign aid globally is its effectiveness.

Research on aid effectiveness has focused on outcomes such as a country’s economic growth or quality of institutions. These studies came to mixed conclusions over whether aid can effectively promote economic development.

Microeconomic evidence paints a reasonably positive picture. The World Bank’s Independent Evaluation Group (IEG) finds that the average rates of return to aid are generally above 20%. Evidence based on randomized program evaluation techniques is also largely positive, indicating that aid-financed interventions can generate substantial benefits for individuals.

The most common approach to evaluating the macroeconomic impact of aid examines the relationship between total aid flows and the economic growth rate. Normally, this has been done with the expectation that, other things equal, countries receiving more assistance would grow more rapidly. Early prima facie evidence suggested the opposite: countries that received the most aid also grew relatively poorly—a paradox often referred to as the micro-macro paradox.

A large number of studies attempted to demystify this paradox. When countries do well for a while, average incomes increase. Donors then tend to transfer less aid. This implies that, over time, the best performing countries receive less aid and the worst performers receive more. A leading study of the World Bank argued that although aid has no impact on growth on average, it can work as long as recipients pursue ‘good’ policies. This result suggested how donors and aid recipients can learn from mistakes in the past to improve aid effectiveness in the future. However, the upshot of the studies that followed suggested aid “is probably not a fundamentally decisive factor for development”.

Recent theoretical exercises give further weight to the need for modest expectations regarding the magnitude of the possible impact of foreign aid on growth. Overall increase in the growth rate accruing from aid inflows of 10 percent of GDP may only be 1- 2.5% depending on the share of aid that is invested and productivity impacts. These effects are very difficult to distinguish from business cycle fluctuations and external shocks at the levels of aid seen by most countries.

The discussion about whether foreign aid works takes place in two platforms. One is the research platform, in papers full of technical language and numbers. Outside, the arguments are plainer and the audience broader. It is far easier to evaluate a school-building project, say, on whether the school was built and children filled its seats than to determine whether all aid improved national school enrollment or made the economy grow faster. The biggest challenge is to show not just that aid went hand-in-hand with economic growth, but caused it.

The one challenge on which views appears to converge is the importance of strong government leadership as well as effective and efficient public institutions as critical ingredients to ensure aid effectiveness. The international development community has been grappling with this problem for decades.

Most aid effectiveness reforms over the years have been focused on improvements at an operational level-- improving management, coordination, evaluation, and project design for technical or capacity-building. These solutions usually miss the underlying political dynamics that block real change. The more fundamental problem undermining aid effectiveness is the assumption that poor governance, weak institutions, and fragile conditions can be fixed through technical assistance. The roles of powerful actors who use their influence to prevent change are typically treated as external to assistance programs, if not ignored altogether.

Development assistance models tend to focus on limiting the power of elite actors through institutional means like anti-corruption bodies or formal legal and judicial institutions. Unfortunately, in too many cases, powerful elites are able to ignore or capture these institutions. Aid effectiveness can be enhanced by shifting the focus to the interests of elite actors, identifying where the interests of certain elites might be served by advancing selected reform, and working to draw those elites into alliance and collective action with others.

This is easier said than done. Advancing reforms will still involve a struggle against powerful actors defending the status quo. But the chances of success are brighter when other powerful elites are on the reform side. In this context, it is important to understand the interests of powerful elite groups, and identify scenarios where they have a shared interest in advancing a set of particular reforms.

Many international development organizations are not adequately equipped to work effectively on these issues. It requires the capacity to acquire a thorough understanding of the range of local actors and institutions, and the history of power struggles in the country, as a foundation for gauging the current environment. It also requires drawing on other disciplines such as social anthropology and political science. The distribution of aid benefits can be heavily influenced by the political interests of those in power inside and outside the government. By overlooking these issues, aid may be slowing down the process of change by contributing to corruption and impunity.

Comments

I would suggest a further differentiator as to aid disbursement is whether it is targeted to the individual or to broad projects. The former is where we see hope that progress can be made, as long as we can get away from cash as the payment method - and we can deliver the funds at an acceptable, auditable cost.
The key to any such aid delivery is to link the settlement with any other funds that may be going to the beneficiary in a single, electronic structure. For instance, they may have government benefits (such as pensions), wages, financial inclusion investments and funds from families at home and abroad.
The last of these is where our non-profit group has been concentrating efforts, with a target of zero cost for both the sender and the recipient as long as the transaction stays electronic.
When a merchant is able to accept electronic payments, i.e. from a mobile-phone based message or even from a card on a mobile POS reader, the zero cost for the merchant as well is another important incentive to motivate all unbanked and under-banked recipients to stay cashless.
It would be naïve to imagine that cash will ever be ruled out entirely, so there does have to be a simple facility to get such funds from local agents. The cost of doing so, under our formula, of 4.5% is within the World Bank and G20 target range, but has sufficient variance with the zero cost as to still incentivize staying cashless.
The other facet we see as being highly desirable for optimizing aid to the poorest is to enable them to use their money for investment, insurance and managing their payments for utilities, rent etc. in as friendly and efficient a manner as possible.
The involvement of national and local governments is clearly important, not least in communicating to the unbanked how they can get these basic financial services - and in helping secure such facilities. Similarly, there is a need for at least one local partner in every country, such as telcos and banks, who will have commercial interests in this delivery format.
We welcome any show of interest from governments and aid agencies looking to distribute funds to the least advantaged, as well as encouraging regulators to contact us to ensure that all aspects of AML and general anti-criminal and tax evasion issues are confronted head on.
The problems of very high costs for P2P transfers, often up to 20%, are significant and need rectifying by joint action. This is not just an unjustified fee on the poor, but is also an encouragement for them to use the black market, operated by criminal groups. The more we can do to make sure the flow of all funds, whether from family, aid agencies, employers or governments, are managed at zero cost, the better for creating effective support for the most needy.

Thanks for commenting Christopher Williams. Interesting thoughts! Not sure I understand how to target official aid given in the form of concessional credit to individuals? Who will be liable for repayment--the government or individuals? How will such a system be enforced?

Given that much of the funding will never be repaid, assuming it is targeted at the most needy, we should look at how to optimize the value proposition in other ways. I do not think that laboring under a debt burden is a good start point for new workers; think of student loan problems in the West and how they create significant stress at a time when we should be encouraging positive thoughts on building a future.
The overall funding we see, as mentioned, comes from a variety of sources, depending on circumstances. Family assistance will always be an important factor - and one to be greatly encouraged - as it has its own personal monitoring. It can also be considered as having an implied debt for those who become successful to hand onto the next generation.
Our core aim of moving to reportable, real time transactions at all levels of society, is so that taxes, duties and fees can be collected by the government in a manner that is seen to be open and fair. That is where 'repayment' can be generated, from those who are capable of building a business that reaches a stage where it can afford to be taxed.
The key aspect of tax collection is to manage it in real time. Wages should be calculated centrally, whether from one employer or many for any individual, with the net settled in conjunction with any other funding sources. Just as importantly, VAT or Sales Tax, should be deducted from the settlement of the clearing of an electronic payment to a merchant or service provider, so there is less room for evasion.
(One separate but attached point on this collection method, relates to the capability of showing suitable respect for the confidentiality of each individual's financial circumstances. The merchant may sell goods at 100, of which VAT is deducted of 10, so the merchant receives 90. The purchaser will have transacted for 100 with the merchant, but may have been entitled to a significant reduction - based on product type, financial circumstance - and only paid 50 at the central clearing point. So, the government will have lost its 10 tax, and the funding source will have paid 40, while the individual will have had complete privacy as to this structure.)
Returning to the question of repayment as a general part of the aid structure, I feel that we should look at the world as it is, rather than how we want it to be. The rich/ poor divide is widening in many parts of the world to a frightening degree, so much of what we see as aid is actually never going to be repaid. It is there to keep a very low floor under those at the bottom of the ladder, in terms of food, clothing and accommodation. But what it can also do is create hope through opportunity for individual achievement to learn and prosper.
To sum up my response, I look at fair, automatic tax collection - just from those who can afford it, as the best way to get 'repayment' of aid, assuming the government is held to reasonable standards of reporting, from those who have received individualized funding in one form or another. Of course, this does not address large scale projects, funded at government level, but it relies on helping the 'light at the end of the tunnel' for those who want to work towards it.
My final point is that the big hole in any such scenario is cash. As we see in the EU, with its $200 billion annual hole in VAT alone through evasion and failed collection, if you allow significantly large cash transactions to escape tax, you blow the system apart. When you have VAT rates that keep going up -now 25% is the norm - you have an ever-increasing reason to evade by choosing the black route. We must work harder to reduce this problem by ensuring we have a reliable transactional flow for everyone to use electronic payments.

Zahidbhai: Thanks for reviving this important issue. Your last point, that it is difficult to advance reforms in the face of powerful elites, raises a fundamental question about aid. How can government-to-government aid be a way of achieving reforms when forces within the government are resisting those same reforms? Elsewhere (http://www.globalpolicyjournal.com/blog/02/12/2013/donors%E2%80%99-dilemma-aid-disruption), I have suggested that aid can be effective only if it is "disruptive." But few governments want to be disrupted. Perhaps aid should be used for only two things: (i) knowledge about government failure that is transferred to the poor, so they can bring pressure to bear on the elites; and (ii) cash transfers so that citizens, not governments, decide what to consume. Shanta

Thanks Shanta for commenting. The poor experience government failure day in and day out, but perhaps they do not always see where it is originating from. So yes we should equip them with knowledge on government failures. Cash transfers are good, but how do we find ways of using aid to build transformative public assets in countries like Bangladesh? What aid delivery mechanisms can effectively do so?

Zahid: Transformative public assets will be built only if there is a political consensus within the country that such assets should be built (and resources redirected from other uses towards these assets). Aid cannot create this political consensus (indeed, it may undermine it, by pushing a project that is one of the donor's "favorites" even if there is no domestic consensus for it). Once such a consensus has been reached, aid can help relax the financing constraint (if there is one), but remember that money is fungible, so aid may simply be financing other expenditures of the government even if it is directed at the transformative project. Shanta